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Stingers: The 2004 State Tax Survey

Tough times can make for tense relations between corporate tax executives and state tax authorities. Our survey suggests that even if economic conditions improve, the stage is set for more contentiousness than ever.

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It's been a rough three years. In September 2000, the California legislature was debating a tax-relief bill intended to lower its "unprecedented surpluses" by giving at least $50 back to every taxpayer. Since then, the state has plunged into fiscal chaos, and voters ousted former governor Gray Davis in favor of Arnold Schwarzenegger. The muscleman-turned-actor-turned-politician took office in November facing a year-end shortfall of $10.2 billion. His first move—delivering on his campaign promise to roll back his predecessor's despised car-tax hike—raised that shortfall to $13.4 billion.

While no state's plight has been illustrated quite as colorfully as California's, almost all the states are in desperate need of funds. At the same time, there's enormous reticence among politicians to raise taxes that directly affect voters—at least until after this year's elections. Add in the lingering disgust among voters over Corporate America's rash of scandals and, suddenly, business is openly in the crosshairs of state governments seeking revenue.

"A governor can say, 'I'm not raising taxes,' but go in and obliterate exemptions," says Brian Murphy, partner in charge of state and local taxation at Grant Thornton. Going after corporate taxpayers, he says, "is always more popular with voters." As one respondent to CFO magazine's latest state-tax survey noted, "We all know that the states need additional revenues, but the anticorporate rhetoric needs to be replaced by cooperation."

That's not likely. To be sure, states continue their competition with one another to woo businesses to their soil through tax incentives and abatements. But the long-running battle over when one state has the right to tax the income of a company in another has reached a turning point.

For years, states have tried to assert that right based on various degrees of physical or economic presence, while companies have planned around such nexus issues. Now, the states have lost enough fights—and are in sufficiently dire economic straits—that they are turning from the courts to the legislatures to short-circuit the nexus question. In the meantime, states continue to pursue revenues through aggressive corporate audits—and even clawbacks of incentives.

Dire States

No matter how irritating this is to corporate tax officials—and anger is a notable feature of our survey responses—no one denies the states need money. Current estimates peg combined state deficits for 2004 at about $80 billion—deeper, notes the liberal Center on Budget Priorities and Policies, than they have been at any time in the past 50 years. An overwhelming majority of survey respondents—81.3 percent—predicted that the state in which they work would be forced to raise taxes, regardless of additional collection or enforcement efforts.

Likely increases are not the only tax-related headache for businesses, however. For example, state tax forms generally mirror those of the Internal Revenue Service, but most states could not afford to follow Washington, D.C.'s lead in offering accelerated depreciation to businesses in 2002, forcing them to decouple their forms and tax codes, and adding to the corporate administrative burden. In Texas, tax refunds exceeding $250,000 can no longer be disbursed without legislative approval. And respondents complained bitterly about the amount of time they spend—or "waste," several said—with state auditors these days.

Yet even CFOs fighting what they see as unfair or unreasonable tactics by various states express some sympathy for the plight of their tormentors. "New York State is in a world of hurt, and I understand that," says Vince Holley, division controller of Wayland, New York-based Gunlocke Co., a division of Hon Industries. "But getting tough on clawback issues may burn them more."

"It is really scraping the [bottom of the] barrel," says Beverly, Massachusetts-based ZymeQuest Inc. CFO C. Evan Ballantyne of his state's efforts to suddenly deny his company an R&D credit it has claimed for seven years. "You start to think to yourself, 'These guys must be so desperate.'"

For states, financial desperation clearly has been coupled with frustration over corporate tax planning. Last July, the Multistate Tax Commission (MTC), an organization of 45 states, released a study claiming that 2001 state corporate-income-tax revenues of $35.4 billion would have been 35 percent higher but for corporate tax sheltering. "It is apparent," the study said, "that various corporations are increasingly taking advantage of structural weaknesses and loopholes in the state corporate tax systems."

The study drew a blistering response from the business-sponsored Council on State Taxation (COST), which argued that corporations pay an additional $358 billion in non-income taxes. But the MTC's broad definition of shelters—to which COST also hotly objected—at least accurately reflects the increasingly dim view that states take of tax planning.

Last year saw rulings in a number of high-profile nexus battles, all revolving around states' efforts to undermine tax-planning techniques involving Delaware holding companies. In most cases, the states lost, causing them to turn from the courts to their legislatures.

Which Exit?

Most prominent among these cases was the decision in Lanco Inc. v. Director, Division of Taxation, a New Jersey ruling that our survey suggests is already as familiar to most corporate tax directors as 1992's Quill Corp. v. North Dakota. In Quill, the U.S. Supreme Court ruled that "substantial nexus" was defined by a physical presence. Thus, North Dakota could not require Quill—an out-of-state office-supplies catalog vendor—to collect use taxes on sales within North Dakota.

The question in Lanco was whether physical presence was also necessary to levy income or franchise taxes. Quill has served as the basis for a decade of corporate tax planning. Typically, affiliated holding companies in tax-friendly states—usually Delaware—own and license intangibles such as trademarks and patents to the operating companies. Those operating companies can then deduct the payments to their affiliates.

In Lanco, New Jersey's tax director had attempted to levy income tax on the Delaware holding company that licenses intangibles to clothing manufacturer Lane Bryant. And there was good reason for Lane Bryant officials to worry that New Jersey's argument of "economic nexus" might prevail: the facts in the case were identical to those in 1993's infamous Geoffrey Inc. v. South Carolina Tax Commission. In that case, the South Carolina Supreme Court ruled that Geoffrey, a Delaware holding company that licensed intangibles to Toys "R" Us, was subject to income tax even though it had no physical presence in the state.

New Jersey was not so lucky—the court cited South Carolina as an aberration and ruled that without physical nexus, Lanco was not subject to the state's income tax. The case also didn't do much for New Jersey's reputation: it rocketed to number one among the states considered by our survey respondents to be the most aggressive about asserting economic nexus. (South Carolina, which was first in 1998 and fifth in 2000, dropped to eighth on the list.)

Yet New Jersey's failure to tax a Delaware holding company was not an unalloyed win for corporate tax planning. Earlier in 2003, Maryland pierced the corporate veil of two Delaware holding companies by arguing that they had no real business purpose other than to avoid tax. That's a classic anti-tax-shelter argument, and one that may signal a much more aggressive approach by the states.

The Maryland Court of Appeals ruled simultaneously in Comptroller of the Treasury v. SYL Inc. and in Comptroller of the Treasury v. Crown Cork & Seal Co. (Delaware) Inc. that the Delaware holding companies of Syms and Crown Cork & Seal could be taxed—not individually, as New Jersey attempted in Lanco, but as part of their parent companies—because they "had no real economic substance as separate business entities."

The court noted that all of the characteristics of a functioning company—employees, office space, travel expenses, and so on—"were virtually nonexistent on Crown Delaware's balance sheets." Where such expenses did exist, they were provided by Organization Services Inc., a "nexus services" provider.

Although Crown Delaware claimed revenues of about $37 million per year, total annual wages for its nine "employees" averaged $568 for each year between 1989 and 1993. Indeed, Crown Delaware's total operating costs averaged just over $2,000 per year. "Over the five-year period in question," the court noted, "Crown Delaware incurred a total of $20 in meals and entertainment, about $60 in telephone charges, and about $100 in postage. Travel costs for the entire period...amounted to less than $7." And despite the fact that Crown Delaware theoretically existed to manage intellectual property, it never incurred any legal fees associated with patents or trademarks.

Those who defend moving intellectual property to a Delaware holding company as a legitimate tax-planning strategy admit that the Crown case is not the most flattering example. But even more-persuasive fact patterns are no sure thing. In a similar case decided in 2002—Sherwin-Williams v. Commissioner of Revenue—Massachusetts failed to convince a court that the paint company's Delaware subsidiary was a sham, because, the court ruled, it did engage in legitimate business activities. This past June, New York's Tax Appeals Tribunal looked at the same affiliate and found just the opposite to be the case.

SYL, Crown, and New York's version of Sherwin-Williams make Delaware-style holding companies far more likely to be attacked in court these days—much as Enron's abuses resulted in greater scrutiny of all special-purpose entities. "If you are a publicly traded company, you need to be far more cautious today than in the past with regard to aggressive tax planning," says Stuart L. Rosow, an attorney with Proskauer Rose LLP. Although such planning is still possible for many companies, he says, "the level of scrutiny that it will be subjected to is much greater."

Nexus End Run

A far more significant development, however, is the number of states that have grown tired of fighting and have simply changed the law. "There are two ways [for states] to attack" an out-of-state company, says Doug Lindholm, executive director of COST. "The first is to say it has economic presence. If that's not going to work, because Lanco says you need a physical presence, [the state] can try to deny the deduction to the company that does have physical presence in the state."

Today, nine states have legislation disallowing deductions taken by one company for payments—such as interest, or royalties on patents—to an affiliated company (see "Legislative Disallowance" later in this article). All but two have passed those laws since 2001. After losing the Sherwin-Williams case, Massachusetts simply changed the law last March to allow the tax commissioner to disallow any deduction that he considers a sham. New York passed tougher laws as well, despite winning its fight with Sherwin-Williams. "In 2003, the floodgates opened," says the tax manager of one Fortune 500 company, who requested anonymity. Although only three states—New York, Massachusetts, and Arkansas—passed such laws last year, seven others considered similar proposals. Typically, these laws require the taxpayer to prove that the affiliated company has a legitimate business purpose.

"My prediction is that within the next three years, most separate-return states will have statutory limitations on related company expenses," says COST legislative director Joe Crosby, "and they'll be all over the board, capturing different types of items."

That means more head-aches for corporations. The distinction between aggressive tax planning and improper tax sheltering is already a huge gray area. By disallowing certain types of intercompany transfers, the new laws potentially affect not just tax planning, but also such run-of-the-mill functions as treasury. Many of the new laws allow the company to justify to the tax commissioner why a particular transfer should be acceptable—but that is another compliance burden.

That complaint was already evident in our survey. Asked about the biggest headache for tax directors, one respondent wrote, "Inconsistent treatment of intercompany transactions—will the state disallow the expense, force combination, or declare affiliate nexus?" Said another: "New legislation that unreasonably denies deduction of intercompany payments."

Expensive Butts

What's most worrying about this new legislation, however, is not whether it's reasonable, but that it isn't likely to produce anywhere near enough money. "In the end," says Michael Lippman, head of KPMG LLP's state and local tax practice, "these income-tax expense-disallowance provisions are not going to be the cure for the states' structural deficit problems, because they can't raise sufficient revenue." Despite the emphasis that corporate income tax often gets in the press and in state capitols, it typically makes up just 5 to 10 percent of state tax collections, says Lippman. The real dollars, he says, come from property tax, sales tax, and the individual income tax.

We asked the 81 percent of survey respondents who said tax hikes were inevitable in the state where they work which taxes they'd like to see raised. Many, apparently, are nonsmoking teetotalers, because sin taxes on cigarettes and alcohol were an overwhelmingly popular first choice (41.5 percent). Unfortunately, Lippman notes that most states "already did the easy things" like raising sin taxes. Consumer sales taxes were a strong second among our respondents (35.4 percent), followed by an even split on individual and corporate income tax (16.2 percent each). "With states having exhausted the easy remedies—delaying payment into a pension fund or increasing fees and cigarette taxes—it will be tougher and tougher for them to close the deficit with anything other than a tax increase," says COST's Lindholm

Although some states have already raised taxes—New York, for example, has raised both sales and income taxes—expect a wave of increases after this year's election season. In the meantime, our survey suggests, corporations are going to have to live with tougher tax administration from states seeking to close their budget gaps. "States are out of money, and they are getting money out of audits even when the bases of their arguments are unreasonable, unfounded, and stupid," wrote one survey respondent. "The tax department is then left with the option of fighting them or giving in."

Tim Reason is a senior writer at CFO.

The 2004 Survey Results

This is the fourth time since 1996 that CFO magazine has surveyed corporate tax officials on their impressions of state tax environments. Given looming state deficits, we added questions this year about whether companies expected increased taxes, aggressive clawbacks, or legislation that would withdraw existing business incentives. States that received the worst ranking appear in boxes throughout the text.

An important characteristic of our survey is that it measures opinion, rather than comparing objective measures such as tax rates or appeal deadlines. After our last survey, in 2000, tax officials from some states, including Massachusetts, told us they were disappointed to get no recognition for big improvements in their administrative environment.

Without a doubt, impressions of unfair treatment die hard. States that topped our lists three years ago as most aggressive or least fair are often there again, even though we cast a much wider net this year, sending surveys to some 5,500 corporate tax officials, with the help of KPMG. We received 130 responses, a 2.3 percent response rate. But the results also reflected significant changes to the tax environment—most notably, New Jersey's precipitous drop in the eyes of corporate taxpayers.

Bad Boys

Were it not for New Jersey crashing the list of the worst five states, little would have changed from previous surveys—the states that corporate tax officials love to hate remain fairly consistent. This year, we simplified our maps to highlight the states that really stand out. The states marked the least (or most) fair and predictable are those whose survey scores deviated from the average by more than one standard deviation.

What is your overall impression of the tax environment in this state? Is it fair and predictable?

5 Least Fair:

New Jersey

California

Massachusetts

New York

Pennsylvania

Ouch!

New Jersey was the falling star of CFO's tax survey. The Garden State's grab bag of tax-law changes in July 2002—particularly the introduction of an alternative minimum assessment (AMA) tax on a corporation's gross receipts—earned it the label of the state with the most unfair and unpredictable tax environment.

In fact, New Jersey was ranked among the five most aggressive or least fair states in seven of eight questions we asked, and respondents said New Jersey's tax policies were the most likely to dissuade companies from relocating to or expanding in the state. That's a stunning change for a state that didn't make the worst five in a single question in our 2000 tax survey, and is well known for actively courting business.

New Jersey was also the only state singled out multiple times by corporate tax officials asked to write in their top headaches. "Using New Jersey as a prime example," wrote one, "state governors and legislatures changing only the corporate income tax to balance their budget without any comprehension as to what it does to business." Another responded, "New, unique taxing schemes, such as New Jersey AMA."

The state's long-held reputation for fair tax administration also took a surprising beating, one that can't be directly attributed to recent legislation. In fact, in the Council on State Taxation's (COST) recent tax-administration scorecard—based on objective differences in state tax laws and policies—New Jersey's score was the same as the average score for all states. And, says COST legislative director Joe Crosby, New Jersey tax-division director Robert Thompson and his staff are generally considered fair and evenhanded. He adds that "New Jersey has an independent tax court that is considered to have decisions that are fair and well reasoned."

Yet CFO's survey, which measures the subjective impressions of corporate tax officials, shows how easily such a reputation can be undone. Tax-court independence was the only subject in which New Jersey wasn't ranked among the worst five states. New Jersey's auditors, by contrast, were rated as the most unfair and unable to settle gray issues of any state's. —T.R.

Hello, Goodbye

How do this state's revenue-department policies and systems influence companies' decisions to locate or expand there?

Least Desirable

New Jersey

California

Massachusetts

New York

Pennsylvania

Kangaroo Courts

How would you rate the independence of this state's administrative appeals process—tax board, administrative law judge, or tax court—from its audit department?

Least Independent

Pennsylvania

Massachusetts

California

Louisiana

Alabama

Black and White

When it comes to settling "gray issues" at the auditor level, which states' auditors are the most unfair or least able to avoid escalation of these issues?

Worst Auditors

New Jersey

California

Massachusetts

Illinois

North Carolina

Friends of Geoffrey

New Jersey again had the dubious distinction of leapfrogging into the lead among most-aggressive states, despite losing the Lanco case. Also notable is Maryland's appearance among the most aggressive states on this map after its courtroom win arguing that certain Delaware holding companies were tax-sheltering shams. Not surprisingly, this map corresponds closely to the map of states that have passed or are considering legislation disallowing company deductions between affilliated companies.

Which states are most aggressive about asserting nexus positions for corporate income tax over corporations with only an economic presence in the state?

5 Most Aggressive

New Jersey

Massachusetts

New York

California

Connecticut

Legislative Disallowance

A growing number of states have passed legislation disallowing deductions for transactions between affiliated companies. In 2003, such legislation was considered, but not enacted, in Maryland, Missouri, Pennsylvania, Rhode Island, Tennessee, Texas, and Wisconsin.

Legislative Repo

Which states' legislatures are likely to eliminate or reduce existing business tax incentives this year?

Most Likely

California

New Jersey

Massachusetts

Illinois

Connecticut

Grabbing for More

Which states are most aggressive about assessing additional tax based on forced combinations and decombinations, IRC ss.482 issues, or business/nonbusiness classifications?

Most Aggressive

California

New York

Massachusetts

New Jersey

Illinois

Clawbacks

Which states are likely to pursue clawbacks of individual company incentives this year?

California

New Jersey

New York

Massachusetts

Illinois

You Are Here

When it comes to aggressively asserting sales-tax nexus, California has held the number-one slot since CFO conducted its first state-tax survey in 1996. Asked if new governor Arnold Schwarzenegger's business-friendly attitude would extend to addressing California's aggressive audits of out-of-state companies, spokesman H.D. Palmer said, "I can't speak to that specific issue," emphasizing instead Schwarzenegger's efforts to aggressively audit the state's own government, and his hopes to improve the climate for California-based businesses.

While no state comes near California's dismal ranking, New Jersey placed a close second, once again making its first appearance among the top-five aggressive states. Its poor ranking in this category could simply reflect general corporate displeasure with the Garden State's recent tax-law changes—which did not include sales-tax changes—but its prodigious leap to the number-two slot suggests its nexus unit has in fact been busier than in the past.

Although long considered an aggressive sales-tax collector, Texas is also a newcomer to the top five. The Lone Star State has recently toyed with such heretical ideas as a state income tax, but it hasn't made significant changes to sales tax. Nonetheless, our survey results—and write-in comments—suggest that the state has significantly increased its nexus efforts. Brian Murphy, Grant Thornton's partner in charge of state and local taxation, says Texas is among the many states that have recently beefed up their nexus units, an impression shared by one respondent who groused, "Texas must have an unlimited audit staff." —T.R.

How would you rate this state's stance on asserting sales/use tax nexus?

5 Most Aggressive

California

New Jersey

New York

Massachusetts

Texas

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